The sudden arrival of the COVID-19 pandemic in the first quarter of 2020 shocked an M&A market that was riding high coming into the year, and in many ways, the impact of the novel coronavirus on M&A deals is still just coming into focus. On June 17, Bass, Berry & Sims attorneys Michael Holley and Frank Pellegrino hosted a webinar roundtable (audio recording available here) to discuss the trends in manufacturing M&A with Scott Alford, Managing Director in Houlihan Lokey’s Industrials Group; Chris Lin, Managing Director at LFM Capital; and Scott Purtill, Partner in Plante Moran’s manufacturing practice.
The panelists discussed evolving trends in manufacturing deal activity, structure, process and terms; the challenges of doing deals during the COVID-19 pandemic; and predictions for the coming months. Key insights from this discussion are highlighted below.
- While deals continued to get done in late March and April, these were mostly deals that had been pretty far along in the process before the full impact of COVID-19 manifested in mid-March.
- Deal pipelines have opened back up through May and June as sellers who have weathered the pandemic’s initial surge well may be looking to capitalize on a period of relative market stability, with more uncertainty looming this fall with a presidential election and a potential second wave of COVID-19.
- Buyers remain active, especially financial buyers trying to stay on schedule with capital deployment after a pause in deal activity during the pandemic’s initial surge.
- Buyers are looking to adjust deal prices based on anticipated COVID-19 impacts and are increasingly using earnouts to bridge to historical financials in the event the business is able to bounce back to those levels.
- Buyers have also been seeking to leverage seller notes to provide financing in the face of suddenly tighter credit markets, though lenders seem to be increasingly willing to underwrite new credit.
- On-site meetings are being delayed until later in the process, with initial management presentations and meetings taking place via videoconference. In some cases, buyers are not getting on-site until after an LOI is in place. Sellers are increasingly prerecording facility tour videos to make available to borrowers earlier in the process.
- In some cases, sellers have started going to market with pre-packaged seller note proposals to help bridge to a higher valuation.
- Buyers are looking for assurances that the target business has the ability to continue to operate in the current environment and are keenly focused on supply chain, inventory and customer/supplier representations. Even in manufacturing businesses, representations around IT and data security are also of increasing importance given the shift to more remote work.
- Buyers are pushing to carve pandemic-related impacts out of the material adverse effect definition, but in many deals, absence of changes representations and interim covenants may be more of a problem for sellers.
- Representation and warranty insurance (RWI) carriers are backing off of broad exclusions for COVID-19 related losses and limiting those exclusions to losses arising from the failure to protect employees, customers and other individuals from transmission of the novel coronavirus.
Excess Working Capital
- Inventory is always a critical issue in manufacturing businesses, but even more so in the COVID-19 era when buyers may not have the same access to target facilities. In addition, Paycheck Protection Program (PPP) loans and other government stimulus may have resulted in the target continuing to produce inventory at a level not supported by current sales. Excess inventory could impact future staffing levels and net working capital targets, among other things.
- If a seller has not been able to collect timely payment of accounts receivable, this could get worse before it gets better.
- In March, many lenders tightened up as existing loans were drawn down to unexpected levels. There has been significant improvement in the debt markets in recent weeks as lenders have gotten more comfortable.
- Nevertheless, borrowers are likely to see marginally reduced leverage ratios, increased interest rates, and higher required equity participation, relative to the pre-pandemic period.
- Lenders are focused on how the business has performed through the initial COVID-19 shock and how the business is recovering.
- Borrowers are taking a cautious approach and talking to a broader group of potential lenders, given tighter credit and potential uncertainty on the horizon.
Contentious Deal Terms
- There is a compelling case for earnouts in a market like this, but earnouts do present challenges. Earnouts are not only difficult to negotiate, as parties haggle over performance metrics, operating covenants, and treatment in the event of future M&A activity involving the company, but they are also famously ripe for post-closing disputes.
- Interim operating covenants are also tricky. In “normal” times, a covenant to operate in the ordinary course consistent with past practice is almost boilerplate, but in an environment where furloughs, forced closures and government stimulus have become commonplace, it is not always clear what it means to continue operating in the ordinary course.
CARES Act Stimulus
- For targets that have taken PPP loans, buyers should consider a number of factors, including legal risk and potential reputational harm, in determining whether to allow the seller to obtain the economic benefit of loan forgiveness. In evaluating legal risk, buyers should carefully diligence the borrower’s eligibility, use of proceeds, and record-keeping, among other things, in light of potential government scrutiny.
- Where targets have taken advantage of payroll tax deferral under the CARES Act, buyers should confirm that the target has recorded this deferral as a liability and determine how to treat this liability at closing (g., as debt, in working capital, etc.).
- Buyers and sellers should be sensitive to potential tax benefits available due to CARES Act provisions allowing businesses to carry back NOLs and recover AMT refundable credits.
Changes Here to Stay?
- Virtual management presentations are likely here to stay. Taking advantage of the ability to conduct management meetings remotely has enabled buyers and sellers to benefit from more potential buyers getting to know management – and doing it earlier in the process. Virtual meetings will not replace on-site visits, but will likely continue to be a part of deal processes going forward.
- There will likely be a renewed focus on the supply chain (risks, contingency plans, etc.) in the post-COVID-19 world, especially in single-source situations.
- Purchase agreements will likely expand to address some of the key issues brought to the fore by COVID-19, and much of this new “standard” language may remain long after the pandemic subsides.
- Deal prices will come down, at least in the short-term, but the panelists agreed that this likely does not signal a broader shift to a buyer’s market in M&A. Most processes for strong companies are still competitive with multiple suitors, and private equity funds need to maintain their investing schedule to deploy capital.
- If more distressed companies are forced to market, we could see more of a buyer’s market develop in that context.